The news that ten banks were given permission to emerge from
under TARP last week, and that several banks may actually do so
as early as last week, has many breathing a sigh of relief that
the banking crisis is over. Unfortunately, the very
measures taken to end our latest crisis all but guarantee that
we’ll shortly witness another round of financial
catastrophe.

This isn’t the kind of news people want to hear these days. When
I’m chatting with friends at a saloon or a dinner party, people
ask me what fixed the financial sector. They aren’t very
interested in hearing that the sector isn’t actually fixed, much
less that the apparent fix is actually making things worse.
Unhealthy Financial Institutions Rally
Let’s begin with the basic fact that no one can quite explain why
or how we ended the bank crisis. The financial sector faces
almost all the same challenges it did last autumn—uncertainty
about profits, outdated business models, heavily leveraged
balance sheets, self-dealing short term thinking by bonus hungry
executives, ineffective regulation and—perhaps most of all—a huge
amount of credit assets of extremely questionable value. Many
things have actually gotten worse. It’s not just subprime debt
anymore. It’s not even just home mortgages. The entire
range of debt products that seem shaky—from credit cards, student
loans, corporate loans to commercial real estate.

Making matters worse, the banks are still dependent on short-term
debt for funding. As Gretchen Morgenson
explains in her column today, some $172 billion of debt will
mature this year, and $245 billion next year. Still in the
midst of a credit crunch, this should be viewed as a ticking
time-bomb for the financial sector.

But it isn't. The market seems to have a renewed confidence in
financial institutions. Since March, financial stocks have
rallied sharply. Several firms once viewed as on their
death beds have raised billions of dollars in new debt and
equity. Some have had to rely on explicit government guarantees
of their debt to issue new bonds but several have issued so
called ‘non-guaranteed’ debt at costs that are far from
unbearable.

Even the government seems to have confidence in the financial
sector. Broad regulatory reforms are being pared back, in favor
of minor tweaks that will largely leave the existing structure
intact. Banks are being allowed to pay back the TARP, escaping
the closest level of scrutiny. Government assistance
programs to the financial sector are being allowed to quietly
fade into the background. Shelving some of the more ambitious
programs—such as Treasury Secretary Tim Geithner’s public private
partnerships to buy troubled assets—isn’t seen as the crisis it
might have once been. It’s okay that their unworkable because the
work they were meant to do seems already done.

The 'No More Lehmans' Rally.
What really seems to have happened is not that one policy or
another fixed the sector. It’s not even the total effect of them
that renewed confidence. Rather, it’s a kind of meta-policy, a
shadow program that repaired things. And that policy is that the
government will do whatever it takes to prevent the collapse of a
major financial institution. There will be no more Lehmans.
Failure is not an option.

Obviously, the policy of No Failure helps banks raise debt.
Holders of bank debt have been protected in each of the
rescues. Unlike the bondholders of Chrysler or General
Motors, the government did not fight to upend the traditional
structure of payouts in failed financial firms. Quite the
contrary, the creditors of banks were made whole in almost every
case.

This creates a very strong incentive to allocate capital toward
the financial sector and away from less secure sectors. Investors
still wary of credit markets find the financial sector more
attractive because of the guarantee that the debt is backed by
the US government. Importantly, this is true even for debt that
is not explicitly backed by the US government. The policy of No
Failure means that banks enjoy a cheaper cost of capital the same
way Fannie Mae and Freddie Mac did in their heyday. Every major
financial institution is now a Government Sponsored Entity.

Beyond access to the credit markets, this implicit guarantee
helps the banks do business. Counter-parties on trades can be
confident that whichever institution they do business with will
be there to make good on the trades. The exogenous risk of modern
day bank runs is gone, and the confidence of customers provides
new opportunities for profits.

Both of these also drive up the price of banks stocks. The
implicit guarantee of bank debt takes away two of the major risks
to holders of financial stocks. First, the government backed
access to new credit dramatically reduces the liquidity risk that
took down both Bear Stearns and Lehman Brothers. Second, the
reduced liquidity risk diminishes the risk that government will
be forced to take over a financial institution. The rally
in financial stocks is partly a result of adding back value that
had been discounted to account for these risks. Add to this the
fact that the business model risk is diminished, and you have a
recipe for a strong rally in bank stocks. Call it the “No More
Lehmans” rally.
The Lurking Risk Management Disaster
At first glance, the process just described would appear to be a
resounding endorsement of the business of government bank
assistance. The usual objections appear either doctrinaire or
just churlish. Free marketeers will object that the government is
too involved, and taxpayers are still on the hook for bank
losses. Profits are being privatized and risk socialized.
Moral hazard is increased by the presence of government
insurance.

None of these typical objections captures the most important
danger created by the implicit guarantees—although the concept of
moral hazard comes close. ‘Moral hazard’ is used as short hand
for the notion that people and institutions will be tempted to
engage in risky behavior if the costs of those risks will be
borne by others. When those risks are correlated with rewards
that can be held privately, risk taking is even more tempting. A
kind of phony, government ‘Alpha’ is created by insurance—excess
gains obtained without taking on commensurate levels of
risk.

The usual solution to this kind of moral hazard is a combination
of risk regulation and profit sharing. Government steps in to
make sure the bets made aren’t too risky, and it takes a share of
the excess gains made from the government alpha. This profit
sharing can reduce risk all by itself, since if done right it
takes away the incentives for risky behavior.

But this notion of moral hazard—and this way of ameliorating
it—misses an even deeper and more systemic problem created by the
implicit guarantee. The problem, to put it in extremely
abbreviated way, is that the implicit guarantee and the knock-on
effects described above make risk management and business
planning almost impossible. They take away the market signals
that could instruct a financial firm about the market’s
collective wisdom about the risks a firm has taken on and the
potential for a firm's business model. The executives running
banks are essentially left flying blind, guessing about the
correct altitude and speed because the market processes that
would be their guidance instruments have ceased
functioning.

Traditional risk management isn’t quite useless, but it is nearly
so. Even somewhat sophisticated measures such as “Value at Risk”
that banks employ don’t really work very well. The banks
themselves admit this, and their failures provide strong
corroborating evidence. The problem is that these measures of
risk are too subjective, and involve too much guess work.

The real test of risk management is provided by the financial
Darwinism of the markets. By reading market signals about
products—pricing of assets, pricing of insurance on those
prices—banks develop models that can inform them about risk. By
reading market signals about their own financial health—their
cost of capital, their borrowing cost, the cost to insure their
debt, the willingness of customers to enter into trades—risk
managers get a view about the risks of their own portfolios and
the strength of the business model.

The “No FMore Lehmans” rally, however, scrambles these signals.
Shareholders, bondholders, counterparties can become indifferent
to risk. Business models can seem more effective than they
actually are. In this situation, financial executives cannot
appeal to the external market to determine whether they have the
right business models, asset portfolios or capital structures.
They just have to guessitimate.

Students of the history of economics may recognize the
similarities between this situation and the old ‘socialist
calculation debate.’ That debate centered on the question of
whether central planners were able to correctly figure out how
much of something should be manufactured in an economy without
price signals. Most everyone today agrees that pricing is
absolutely central to the ability to make calculations about how
to expend limited resources.

With the implicit guarantees in place, the bank executive trying
to decide how to change his firm’s business model or what it’s
risk portfolio is in the position of a socialist planner. He
lacks the ability to calculate risk and reward because his access
to the judgment of an external market is cut-off.

This calculational chaos is far worse than simple ‘moral hazard.’
It doesn’t matter what regulations are in place, or how closely
supervised a firm might be. After all, the regulators and
supervisors suffer from the same blindness of the bank
executives. And even if bank executives are well-intentioned and
untempted by moral hazard, they still cannot properly decipher
the risks in their business. There’s no process for decoding risk
except market processes, and we’ve thrown a giant monkey wrench
into that process. In short, our implicit guarantees are wrapping
the mystery of risk inside the enigma of bailouts.

It was this calculational chaos that brought down Fannie Mae and
Freddie Mac. Even when closely supervised by regulators and with
well-intentioned executives in place, the mortgage agencies were
unable to properly evaluate the size of their balance sheets, the
content and quality of their portfolios or the appropriateness of
their business models. They were the original ‘flying blind’
financial institutions, operating under the benefits and hazards
of ‘No Failure’ even before the collapse of Lehman Brothers.

And there is every reason to believe that this calculational
chaos will also bring down financial institutions covered by the
government’s implicit guarantee. The question is not, really,
whether banks will fail like Fannie and Freddie. The question is
how many will fail. Or, perhaps, how many will be able to avoid
the fate through some bit of luck. Financial prudence and
managerial skill will not be enough.

No Exit?
Policy makers face a tough problem here. In order to restore the
health of the financial sector, they need to remove the blinders
that the implicit guarantees place on those running these firms.
But they never succeeded in doing this with Fannie and Freddie,
despite years of denial that any guarantee existed. After the
market was proved correct about Fannie and Freddie—there was a
guarantee after all—the government simply lacks credibility on
this point. No one seriously believes these days that a firm like
Morgan Stanley or Goldman Sachs would be allowed to fail, much
less a mega-bank like Citi or Bank of America.

Perhaps something as dramatic as the seizure of Citigroup is
necessary to restore the credibility of markets in the financial
sector. This, actually, is exactly what the Wall Street Journal’s
editorial board recommended last week. But we need to be
cautious: the market has already responded to the guarantees in
so many ways that if they were effectively removed, the process
would be painful to many investors and the ripple effects are
unknowable. We might even set off a new round of financial panic,
as the markets suddenly tried to work out which institutions were
viable on market processes without guarantees.

This much we know: the scheme to save the banks through implicit
guarantees is doomed to failure. What we should do about this,
and if we can do something about it before it’s too late—well,
those should be the questions we’re talking about.